Using purchasing power parities to compare countries: Strengths and shortcomings

Good international economic policy requires good comparative data on national economic performance. In May 2020, the World Bank published the latest comprehensive update of purchasing power parities (PPPs), as part of the International Comparison Program. Produced for 176 countries, these PPPs are used to convert data (especially GDP and other quantities based on national income accounts) from national currencies to a common basis in a way that is meaningful for economic analysis. PPP-adjusted data are essential because the distortions caused by sharp exchange rate movements are significant, especially for times of macroeconomic turbulence.

The newly released PPP data contain fewer surprises than those published in previous updates and are an invaluable tool, but Honohan explains why PPPs should be used with caution and an understanding of their limitations. Apart from removing distortions caused by market exchange rate movements, PPPs remove the impact of other factors affecting relative prices, especially productivity differences, which Honohan argues should not be removed if one wishes to compare the overall economic size or strength of a country or region. Adjusting for productivity, he finds that the United States retains its position as the world’s largest economy for the time being, and the European Union (even without the United Kingdom) is just ahead of China.